Systematic Relative Strength

Conventional wisdom says you don’t need anything more complicated than a 60/40 portfolio. From the WSJ:

Investment advisers and managers usually recommend some variant of 60% stocks and 40% bonds (with fewer stocks and more bonds as you get older). The portfolio should be rebalanced at least once a year—selling some of what has done well to buy more of what has done poorly, restoring the target proportions.

The theory is that when stocks do badly bonds will do well, and vice versa. But the theory is flawed.

Historically, this portfolio has only succeeded when stocks, or bonds, or both, have been reasonably valued or cheap. In the past, if you had invested in this portfolio when stocks and bonds were both overvalued, it proved a very poor deal.

Using data on stock and bond returns from New York University’s Stern School of Business and inflation data from the Labor Department, I looked at how such a portfolio performed in the past when measured in real, inflation-adjusted dollars.

It lost a third of its value from 1928 to 1932, and it lost value over two longer periods as well, from 1936 to 1947 and from 1968 to 1982—even before deducting taxes and costs. In reality, most investors would have done very badly indeed.

Another theory that doesn’t hold up when subjected to real data.

So what are your alternatives? How about expanding the investment universe to include domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income. John Lewis conducted a rigorous test of this type of Tactical Asset Allocation strategy in this 2012 white paper. Of particular interest in light of this WSJ article, note the performance of the Tactical Asset Allocation strategy compared to a 60/40 portfolio over time.

From John Lewis’ white paper:

Table 2 shows a summary of returns using different lookback periods for various relative strength ranking factors. Once again, the robust nature of relative strength is shown by the ability of multiple random trials to outperform using a variety of factors. Some of the intermediate-term factors work better than others, but they all exhibit a significant ability to outperform over time. At very short lookback periods, such as 1 month, the performance is not as good as at longer periods. Relative strength models are not designed to catch every small wiggle, and investors need to allow positions to ebb and flow over time. It is also clear from Table 2 that as you begin to lengthen your lookback period, returns begin to degrade. While a long-term buy and hold approach to a relative strength strategy is necessary, the investments within the strategy are best rotated on an intermediate-term time horizon.

We have employed this type of tactical approach to portfolio management in The Arrow DWA Tactical Fund (DWTFX) and our Global Macro separately managed account. DWTFX is +25.70% YTD through 12/27/13 and has outperformed 95 percent of its peers in 2013.

Source: Morningstar

Investors may benefit from looking beyond just domestic equities and domestic fixed income when deciding what strategies they want to employ to get them through the next couple of decades.

Past performance is no guarantee of future returns.

This entry was posted on Monday, December 30th, 2013 at 8:56 am and is filed under Relative Strength Research, Tactical Asset Alloc. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.